MCQ

Use the information below to answer Q1 to Q6

Angela Green, an investment manager at Horizon Investments, intends to hire a new investment analyst.
After conducting initial interviews, Green has narrowed the pool to three candidates. She plans to
conduct second interviews to further assess the candidates’ knowledge of industry and company analysis.
Prior to the second interviews, Green asks the candidates to analyse Chrome Network Systems, a
company that manufactures internet networking products. Each candidate is provided Chrome’s financial
information, presented in Exhibit 1.

Network Systems Selected Financial Information ($ millions)

YEAR ENDED: 2018 2019 2020
Net sales 46.8 50.5 53.9
Cost of sales 18.2 18.4 18.8
Gross profit 28.6 32.1 35.1
SG&A 19.3 22.5 25.1
Operating income 9.3 9.6 10.0
Interest expense 0.5 0.7 0.6
Income before provision for income tax 8.8 8.9 9.4
Provision for income taxes 2.8 2.8 3.1
Net income 6.0 6.1 6.3
Green asks each candidate to forecast the 2021 income statement for Chrome and to outline the key
assumptions used in their analysis. The job candidates are told to include Horizon’s economic outlook for 2021
in their analysis, which assumes nominal GDP growth of 3.6%, based on expectations of real GDP growth of
1.6% and inflation of 2.0%.
Green receives the models from each of the candidates and schedules second interviews. To prepare for the
interviews, Green compiles a summary of the candidates’ key assumptions in Exhibit 2.

Exhibit 2  Summary of Key Assumptions Used in Candidates’ Models

CANDIDATE A
• Net sales Net sales will grow at the average annual growth rate in net sales over 2018–2020
• Cost of sales 2021 gross margin will be the same as the average annual gross margin over 2018–2020
• SG&A 2021 SG&A/net sales ratio will be the same as the average ratio over 2018-2020
• Interest expense 2021 interest expense assumes the effective interest rate will be the same as the 2020 rate
• Income taxes 2021 effective tax rate will be the same as the 2020 rate.
CANDIDATE B
• Net sales Industry sales will grow at the same rate as nominal GDP, but Chrome will have a 2 percentage
points decline in market share.
• Cost of sales 2021 gross margin will decline as costs increase by expected inflation.
• SG&A 2021 SG&A will grow at the rate of inflation.
• Interest expense 2021 interest expense will be the same as the 2020 interest expense.
• Income taxes 2021 effective tax rate will equal the blended statutory rate of 30%.

CANDIDATE C
• Net sales Net sales will grow 50 basis points slower than nominal GDP.
• Cost of sales 2021 gross margin will increase by 20 basis points from 2020.
• SG&A 2021 SG&A/net sales ratio will be the same as the 2020 ratio.
• Interest expense 2021 interest expense will be the same as the average expense over the 2018-2020
• Income taxes 2021 effective tax rate will be the same as the average effective tax rate over 2018-2020
Question 1
• Based on Exhibit 1, which of the following provides the strongest evidence that Chrome displays
economies of scale?
• A. Increasing net sales
• B. Profit margins that are increasing with net sales
• C. Gross profit margins that are increasing with net sales

• Economies of scale are a situation in which average costs decrease with increasing sales volume.
Chrome’s gross margins have been increasing with net sales. Gross margins that increase with
sales levels provide evidence of economies of scale, assuming that higher levels of sales reflect
increased unit sales. Gross margin more directly reflects the cost of sales than does profit margin.
2018 2019 2020
Net sales 46.8 50.5 53.9
Gross profit 28.6 32.1 35.1
Gross margin 61.11% 663.56% 65.12%
Question 2
• Based on Exhibit 2, the job candidate most likely using a bottom-up approach to model net sales
is:
• A. Candidate A.
• B. Candidate B.
• C. Candidate C.

A bottom-up approach for developing inputs to equity valuation models begins at the level of the
individual company or a unit within the company. By modelling net sales using the average annual
growth rate, Candidate A is using a bottom-up approach. Both Candidate B and Candidate C are
using a top-down approach, which begins at the level of the overall economy.
Question 3
• Based on Exhibit 2, the modeling approach used by Candidate B to project future net sales is most
accurately classified as a:
• A. hybrid approach.
• B. top-down approach.
• C. bottom-up approach.

• A top-down approach usually begins at the level of the overall economy. Candidate B assumes
industry sales will grow at the same rate as nominal GDP but that Chrome will have a 2
percentage points decline in market share. Candidate B is not using any elements of a bottom-up
approach; therefore, a hybrid approach is not being employed.
 Question 4
• Based on Exhibits 1 and 2, Candidate C’s forecast for cost of sales in 2021 is closest to:
• A. $18.3 million.
• B. $18.9 million.
• C. $19.3 million.
CANDIDATE C
Net sales Net sales will grow 50 basis points slower than nominal GDP.
Cost of sales 2021 gross margin will increase by 20 basis points from 2020.
SG&A 2021 SG&A/net sales ratio will be the same as the 2020 ratio.
Interest expense 2021 interest expense will be the same as the average expense over the 2018-2020
Income taxes 2021 effective tax rate will be the same as the average effective tax rate over 2018-2020

2021 gross margin = 2020gm +20bps 35.1/53.9 + 0.20% = 65.12% + 0.20% 65.32%
2021 COGS/net sales = 100%-gross margin 100% - 65.32% 34.68%
2021 net sales = 2020 net sales * (1+ nominal GDP – 0.50%) 53.9m * (1 + 0.036 – 0.005) $55.57m
2021 cost of sales = 2021 net sales * COGS/net sales 55.57 *34.68% $19.27m
Question 5
• Based on Exhibits 1 and 2, Candidate A’s forecast for selling, general, and administrative expenses
in 2021 is closest to:
• A. $23.8 million.
• B. $25.5 million.
• C. $27.4 million.

Net sales Net sales will grow at the average annual growth rate in net sales over 2018–2020
Cost of sales 2021 gross margin will be the same as the average annual gross margin over 2018–2020
SG&A 2021 SG&A/net sales ratio will be the same as the average ratio over 2018-2020
Interest expense 2021 interest expense assumes the effective interest rate will be the same as the 2020 rate
Income taxes 2021 effective tax rate will be the same as the 2020 rate.
Net sales Net sales will grow at the average annual growth rate in net sales over 2018–2020
Cost of sales 2021 gross margin will be the same as the average annual gross margin over 2018–2020
SG&A 2021 SG&A/net sales ratio will be the same as the average ratio over 2018-2020
Interest expense 2021 interest expense assumes the effective interest rate will be the same as the 2020 rate
Income taxes 2021 effective tax rate will be the same as the 2020 rate.

SG&A/ net sales ratios are calculated as follows:

2018 2019 2020
Net sales $46.8 $50.5 $53.9
SG&A expenses 19.3 22.5 25.1
SG&A to sales ratio 41.24% 44.5% 46.57%

Growth rate in sales:

2011 ($50.5 /$46.8) -1 = 7.91%
2012 ($53.9 / $50.5) -1 = 6.73%

Average SG&A/ net sales, 2018-2020 (41.24% + 44.55% +46.57%)/3 44.12%

Average annual growth sales in net sales, 2018-2020 (7.91% + 6.73%)/2 7.32%
2021 net sales = 2020 net sales * (1 + avg annual growth rate in net sales) $53.9m * 1.07032 $57.85m
2021 SG&A = 2021 net sales * Average SG&A/ net sales $57.85m * 44.12% $25.52m
Question 6
• Based on Exhibit 2, forecasted interest expense will reflect changes in Chrome’s debt level under
the forecast assumptions used by:
• A. Candidate A.
• B. Candidate B.
• C. Candidate C.
CANDIDATE A
• Net sales Net sales will grow at the average annual growth rate in net sales over 2018–2020
• Cost of sales 2021 gross margin will be the same as the average annual gross margin over 2018–2020
• SG&A 2021 SG&A/net sales ratio will be the same as the average ratio over 2018-2020
• Interest expense 2021 interest expense assumes the effective interest rate will be the same as the 2020 rate
• Income taxes 2021 effective tax rate will be the same as the 2020 rate.

CANDIDATE B
• Net sales Industry sales will grow at the same rate as nominal GDP, but Chrome will have a 2 percentage
points decline in market share.
• Cost of sales 2021 gross margin will decline as costs increase by expected inflation.
• SG&A 2021 SG&A will grow at the rate of inflation.
• Interest expense 2021 interest expense will be the same as the 2020 interest expense.
• Income taxes 2021 effective tax rate will equal the blended statutory rate of 30%.

CANDIDATE C
• Net sales Net sales will grow 50 basis points slower than nominal GDP.
• Cost of sales 2021 gross margin will increase by 20 basis points from 2020.
• SG&A 2021 SG&A/net sales ratio will be the same as the 2020 ratio.
• Interest expense 2021 interest expense will be the same as the average expense over the 2018-2020
• Income taxes 2021 effective tax rate will be the same as the average effective tax rate over 2018-2020
Question 6
• Based on Exhibit 2, forecasted interest expense will reflect changes in Chrome’s debt level under
the forecast assumptions used by:
• A. Candidate A.
• B. Candidate B.
• C. Candidate C.

• In forecasting financing costs such as interest expense, the debt/equity structure of a company is
a key determinant. Accordingly, a method that recognizes the relationship between the income
statement account (interest expense) and the balance sheet account (debt) would be a preferable
method for forecasting interest expense when compared with methods that forecast based solely
on the income statement account.
• By using the effective interest rate (interest expense divided by average gross debt), Candidate A
is taking the debt/equity structure into account whereas Candidate B (who forecasts 2021 interest
expense to be the same as 2020 interest expense) and Candidate C (who forecasts 2021 interest
expense to be the same as the 2018-2020 average interest expense) are not taking the balance
sheet into consideration.